SocGen - Will Europe delay the Fed?

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Macro Commodities Forex Rates Equity Credit Derivatives

Please see important disclaimer and disclosures at the end of the document

1 June 2010

EconomyBeyond the cycle

www.sgresearch.com

Stephen GallagherChief US Economist

(1) 212 278 [email protected]

Aneta MarkowskaSenior US Economist

(1) 212 278 [email protected]

Martin RoseResearch Associate(1) 212 278 [email protected]

Fed officials are being pulled in opposite directions. The US recovery is growing deeper rootsand may require scaling back exceptional policy measures. However, the European debt crisishas forced the Fed to take a small step back by reopening FX swap lines. It has also pushedback market expectations for rate hikes. But how much is Europe really worth to the Fed?

Q Europe unlikely to derail US recovery So far, economic evidence shows no signs ofspillover of the European troubles into the US economy. Employment growth has finally

materialized and income gains are shoring up the consumer. Meanwhile, businesses are

restarting their capex plans and we see a lot of room for further gains in business investment.

Our baseline scenario is that the European turmoil will have limited impact on the US

economy. The Fed would then still be in a position to hike in December.

Q Whats Europe worth to the Fed? The key risk on the Fed outlook is not the economy, butfinancial conditions. In an effort to quantify the potential impact of market turmoil on the Feds

decisions, we have created an empirical Taylor rule which captures economic as well as

financial conditions. If financial conditions remain as stressed as they are today, this would

shave about 40 bps from the neutral fed funds rate relative to our baseline scenario and would

delay the Fed by about a quarter. A further deterioration in financial conditions could shave a

full percent from the neutral fed funds rate and delay the Fed by two to three quarters.

American ThemesWill Europe delay the Fed?

Financial conditions in the Taylor rule

-10%

* Alternative Scenario #1: Financial conditions do not imp rove

* Alternative Scenario #2: Financial conditions deter iorate fur ther

The augmented Taylor Rule includes starndard economic variables plus the SG Financial Conditions Index. Coefficients are fitted on post-1989 Fed decisions

SG Financial conditions index is comprised of 14 market variables which include: TED spread, 2y-ff spread, 10yr-2yr Treas spread, 10y-3m Treas spread, 10y-

3m Treas spread, 6m swap spread, BAA corp spread, HY corp spread, Muni spread, Mtg spread, SPX detrended, VIX, money supply growth, bond-eqty correl

Taylor Rule ScenariosSG Financial Conditions Index

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

87 89 91 93 95 97 99 01 03 05 07 09 11 13

%

Fed Funds Rate

Baseline Scenario

Al te rnat ive Scen ari o #1 *


-8.0

-7.0

-6.0

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

87 89 91 93 95 97 99 01 03 05 07 09 11 13

%

Baseline ScenarioAl te rnat ive Scen ari o #1 *


Source: Global Insight, Bloomberg, SG Cross Asset Research

This document is being provided for the exclusive use of MARTIN ROSE (SGCIB)


2/17

American Themes

21 April 2010

Economic outlook and monetary policyDespite further improvements in the economic performance, the Fed continues to talk softly.

At the latest FOMC meeting on April 28, the Fed chose to maintain its commitment to an

extended period of low rates. Two weeks later, the Fed was forced to take a step back in its

exit plan by reopening FX swap lines with foreign central banks. European debt problems may

have temporarily delayed the Feds exit plan, but we see recent market turmoil as a re-pricing

of risk rather than a re-pricing of economic expectations. Our baseline view is that European

debt problems will slow European growth, but will have only limited impact on the US. As the

US recovery continues, the Fed will be pressured to normalize its policy setting.

Back in March, Bernanke outlined the following sequence of exit steps: (1) test tools for

draining liquidity (2) scale up liquidity draining operations and (3) increase interest paid on

excess reserves (IOER). While still in testing stages with respect to reverse repos and Term

Deposit Facility (TDF), the Fed has already used its SFP (Supplemental Financing Program) on

a small scale to achieve some liquidity withdrawal.

Of course, the timing and speed with which the sequence is implemented will depend largely

on the economic outlook. Logically, this is the starting point of our discussion on the Fed

outlook. Later on, we will incorporate financial conditions into our fundamental framework.

This allows us to estimate the potential impact of recent market turmoil on the Feds

decisions.

The importance of the output gapTiming policy exits is never easy, but there are many complicating factors in this cycle. Among

them is the uncertainty about the size of the output gap. Whether measured as deviation of

GDP from potential, or deviation of unemployment from NAIRU, estimating the output gap

requires making an assumption about the underlying capacity of the economy. Some think

that the crisis has not altered the path of potential growth or the level of NAIRU: others believe

that potential output has been altered significantly.

Given the wide range of assumptions about the output gap, the estimates of the neutral fed

funds rate have also varied enormously in the past year. The Congressional Budget Office,

whose estimates are used routinely by economists, still assumes NAIRU near 5%. This

assumption translates to a neutral fed funds rate of -1.75% and suggests no rate hikes until

Q1 2012 (or when unemployment falls below 8.5%). Yet, many economists, including some at

the Fed, have shifted their NAIRU estimates higher since the onset of the crisis. The Fed

began publishing its long term economic

projections in February 2009, and since then

its long term unemployment forecast rangehas increased from 4.5%-5.5% to 4.9%-

6.3%.

Our own view lies at the upper end of the

Feds range. We see the rise in

unemployment as partly cyclical, partly

structural. Many of the jobs lost in this

downturn e.g. in construction and finance

have been lost permanently. The BLS

Unemployment Rate Cyclical vs. Structural

0

2

4

6

8

10

12

65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10

%

UR

UR excluding LT unemployment

Linear (UR excluding LT unemployment)

Source: Global Insight, SG Cross Asset Research

The Bernanke sequence1. Test tools for draining liquidity

(reverse repos, term deposits)

2. Scale up liquidity draining

operations

3. Increase Interest Paid on

Reserves (no explicit mention of

the fed funds target, but likely to

be hiked simultaneously)

#2 and #3 may occur

simultaneously if developments

were to require a more rapid exit

Source: SG Cross Asset Research

Evolution of Feds NAIRU Estimates

4.0

4.5

5.0

5.5

6.0

6.5

J an-09 Apr-09 J ul-09 Oct-09 J an-10 Apr-10

%

Lines represent the Fed's range;

boxes represent central tendency

Source: Federal Reserve



3/17

American Themes

1 June 2010 3

(Bureau of Labor Statistics) data shows that 42% of the unemployed have been out of work

for more than six months. That accounts for 4.2% out of the 9.9% official unemployment rate.

These displaced workers many of them in construction, real estate and finance are not

necessarily competing for job openings in other sectors. As such, their downward impact on

wages should not be overestimated. Using BLS figures on long-term unemployment, we have

backed out a short-term unemployment rate which essentially eliminates structural changes in

the economy. This adjusted figure currently stands at 5.6% vs. a long term average of 4.9%.

We conclude that NAIRU has moved substantially above the CBO s 5% estimate. Our own

estimates derived from an HP (Hodrick-Prescott) filter on unemployment data put NAIRU

closer to 6.3%. This happens to be the upper end of the Feds range. Our estimate suggests

the neutral fed funds rate is currently around -0.5% and will turn positive in the first half of

2011.

The importance of NAIRU and the potential policy pitfalls

-5.0

0.0

5.0

10.0

15.0

20.0

58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12

% Fed Funds Rate

TR (based on CBO NAIRU)

TR (based on SG NAIRU)

0.0

2.0

4.0

6.0

8.0

10.0

12.0

58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12

% UR

NAIRU (CBO)

NAIRU (SG - HP Filter)


The standard Taylor rule was created to give a simple rule-based approach to policy, not to

forecast the Feds actual decisions. Indeed, during the modern era of monetary policy making,

the Fed has tended to undershoot the standard Taylor Rule during economic downturns. To

capture the Feds actual, rather than hypothetical behaviour, we have estimated empirical

Taylor Rules on post-1987 data - that is when Greenspan took over the Fed. The results show

a much greater sensitivity to the output gap. Projecting forward the Feds asymmetric

behaviour during economic downturns, we estimate that the Fed would currently be targeting

a fed funds rate between -1.1% and -2.1%.

Standard Taylor rule results undervarious NAIRU assumptionsNAIRU

Prescribed

Rate

First rate

hike

Fed's

low 5% -1.75% Q1'12

Fed's

high 6% -0.45% Q2'11




4/17

American Themes

21 April 2010

Empirical Taylor Rules

-5.0

0.0

5.0

10.0

15.0

20.0

58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15

% Fed Funds Rate

TR (based on CBO NAIRU)

TR (based on SG NAIRU)


The importance of financial conditionsAnother drawback in using traditional Taylor rules is that they only consider the economic

backdrop while completely ignoring financial conditions. Financial conditions matter

tremendously because they can enhance or disrupt the Feds efforts to manage the economic

cycle. Indeed, since financial conditions are pro-cyclical (i.e. they tighten during economic

downturns and ease during expansions), they tend to undermine the Feds efforts to either

stimulate or restrict growth. This implies that the Fed needs to overreact to the economic

evidence in order to compensate for tight or easy financial markets.

Including financial conditions as a variable in the Taylor ruleproduces slightly lower prescribed rates during economic

downturns and higher rates during economic expansions. For

the latest downturn, this expanded Taylor Rule would have done

a much better job anticipating the Feds moves.

As of Q1, our expanded Taylor Rule was putting the neutral fed

funds rate at -0.6%. Financial conditions, which were on the

accommodative side, were boosting the otherwise prescribed

rate by about 50bps. Assuming that financial conditions

continue to improve along normal cyclical patterns, the

prescribed rate would turn positive in the first half of 2011, end

the year at 0.8% and rise to 3.3% by end of 2012.

1SG Financial conditions index is comprised of 14 market variables which include: TED spread, 2y-fed fund spread, 10yr-

2yr Treas spread, 10y-3m Treas spread, 10y-3m Treas spread, 6m swap spread, BAA corp spread, HY corp spread, Muni

spread, Mtg spread, SPX detrended, VIX, money supply growth, bond-eqty correl. The FCI index is a weighted average of

the first three principal components. The weights are determined by regressing GDP on these components.

SG Financial Conditions Index 1

-9

-8

-7

-6

-5

-4

-3

-2

-1

0

1

2

89 91 93 95 97 99 01 03 05 07 09

Source: Bloomberg, SG Cross Asset Research



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American Themes

1 June 2010 5

Taylor rules with financial conditions

* Alternative Scenario #1: Financial conditions do no t im prove* Alternative Scenario #2: Financial conditions deter iorate fur ther

SG Financial Conditions Index

Taylor Rule Scenarios

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

87 89 91 93 95 97 99 01 03 05 07 09 11 13

%Fed Funds Rate

Baseline ScenarioAlt er nat ive Scen ari o #1 *

Alt er nat ive Scen ari o #2 *

-8.0

-7.0

-6.0

-5.0

-4.0

-3.0

-2.0

-1.0

0.01.0

2.0

87 89 91 93 95 97 99 01 03 05 07 09 11 13

%

Baseline Scenario




Of course the Greek crisis, which has mushroomed from a regional problem to a global

financial problem, has altered the picture significantly. The deterioration in financial conditions

over the past few weeks is worth about 50bps in terms of the fed funds rate. In other words, if

the contagion is not broken and financial markets continue to deteriorate, the Fed would likely

delay its exit. The charts below show two alternative scenarios, one in which

financial conditions do not improve, and another where they deteriorate

further. The impact on Fed policy is not negligible, and could potentially be

even more pronounced if the deterioration in the financial markets has knock-

on effects on the real economy.

Producing prescribed policy rates is one thing, but interpreting them is

another thing, particularly in light of the negative prescribed rates. In a simple

world, the Fed would fully drain excess reserves by the time neutral rate

returns to zero. Rate hikes would come next. A more likely scenario is that

there will be some overlap between the liquidity drain and rate hikes. In other

words, the Fed may have to begin hiking ahead of schedule in order to

offset the impact of excess reserves in the system and to stop inflation

expectations from breaking out.

Summary of Taylor Rule Estimates as of Q1Q1' 2010 YE 2010 YE 2011 YE 2012

Standard Rules

CBO NA IRU -1.75 -1.90 -0.46 1.90

SG NAIRU -0.44 -0.58 0.79 3.00

Emp irical Rules

CBO NA IRU -2.04 -2.10 -0.63 1.97

SG NAIRU -1.10 -1.10 0.25 2.69

Emp irical w ith FCI

CBO NA IRU -1.52 -1.71 -0.19 2.37

SG NAIRU -0.63 -0.82 0.67 3.16

Underlying Economic Assumptions

UR 9.70 9.40 8.70 6.80

Core PCE 1.30 1.00 1.49 1.80




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American Themes

21 April 2010

Can the US decouple from Europe? And will Europe Delay the Feds exit?When the US economy collapsed on the back of the sub-prime crisis, Europe could not escape the

fallout. Is the US economy equally vulnerable to a European debt crisis?

Some market observers have drawn comparisons between the current situation and the sub-prime

crisis that morphed into a full blown financial meltdown. Of course, the key similarity between the

two crises is the transmission of potential losses through the banking sector, which is already

showing liquidity strains. Yet, it may be worthwhile to consider some key distinctions.

1. Asymmetric bank exposure: Sub-prime assets were held in equally large amounts by both US

and European banks, therefore transmitting a problem that originated in the US to the European

economy. This time, US banks do not have any significant exposure to European sovereign debt.

2. Asymmetric trade flows: The sub-prime crisis was also transmitted to Europe via the export

markets which suffered heavily from the collapse in US demand. This process is also asymmetric,

because the US is not as dependent on exports to Europe as Europe is on the US.

3. Household balance sheets not at risk: The last difference is that the sub-prime crisis was

transmitted to the US economy not only via bank balance sheets, but also via household balance

sheets which suffered strong negative wealth effects. This time, US households do not have any

exposure to the troubled assets.

Of course, that does not mean that the US economy is completely immune to further deepening of

the European debt crisis. We see two potential transmission channels:

1. Equity market losses could put pressure on household balance sheets and spark a rise in the

savings rate. However, the negative wealth effects are unlikely to be as pronounced as in 2008 in

the absence of further house price deflation.

2. Wider credit spreads could increase the cost of capital for businesses and restrain business

investment. This adverse impact may be partially mitigated by the impact of safe-haven flows on

the Treasury market which have pushed yields down.

3. Stronger dollar Although the US can live with weaker exports to Europe, it could experience a

growth slowdown due to weaker external demand and loss of competitiveness. We estimate that a

drop in the EUR-USD to parity would produce a direct effect of shaving US GDP by about 0.3%.

However, contagion is also pushing the dollar higher against nearly all currencies, which could

amplify the damage inflicted on US exporters.

In conclusion, the US economy is not completely immune from financial contagion, but there is a

considerable asymmetry in the sub-prime episode which originated in the US and the sovereign

debt episode which originated in Europe. The transmission mechanisms in this case are not as

pronounced. In this sense, the current situation is more like the 1997-98 series of emerging market

crises rather than the sub-prime crisis in reverse. The emerging market debt crises which

culminated with the Russian debt default amounted a significant market event, but one that had a

limited impact on the real economy. The Fed responded to tighter financial conditions by easing

monetary policy in 1998, but was forced to reverse course and hike aggressively in 1999. Similarly,

the European debt crisis may delay the Feds exit plans, but if the impact on the US economy is

limited, the Fed may have some catching up to do in 2011.



7/17

American Themes

1 June 2010 7

Fed balance sheet action moves to liability sidePrior to the European debt crisis, the Fed has closed all but one balance sheet expansion

programs and the Feds assets were expected to level off around $2.3 trln. Reopening the FX

swap lines could trigger further expansion, although to participation in the program has been

small so far. In the first week, FX swaps added only $9bln to the Feds assets and by the third

week the amount has shrunk to just $1.2 bln. The low participation by European banks is due

to prohibitively expensive rates charged on the loans which, at OIS+100bp, are currently 69

basis points above 3m Libor.

We do not anticipate much growth in the Feds balance sheet from the current $2.3 trln. Going

forward, the action is clearly moving from the asset side to the liability side. The latest FOMC

statement reaffirmed that liquidity and asset purchase programs will not be renewed. The only

program still in operation is TALF, but only for loans backed by newly issued CMBS collateral.

This program is set to expire in June, and it is unlikely to add substantially to the Fed s assets

between now and then.

The Feds next focus will be normalizing liquidity and unwinding extraordinary policy

measures. In a perfect world, cleaning up the Feds balance sheet would be done by

unloading assets, but outright sales could lead to dislocations in the still-fragile credit markets.

We think that asset sales are unlikely in the near-term. The balance sheet will shrink only

gradually as cash flow on the Feds investment is not reinvested back into the market.

Fed balance sheetFed Assets

-

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400

J an-07 J ul-07 J an-08 J ul-08 J an-09 J ul-09 J an-10

USD bln

Emergency Liqui dity Programs

Long-term Assets

Fed Liabilities

-

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400

J an-07 J ul-07 J an-08 J ul-08 J an-09 J ul-09 J an-10

USD bln

Treasury Supplemental Financing Program (SFP)

Bank Reserves

Other assets (primarily currency)

Excess reserves peaked inlate February. Since then,

Treasury has issued $200

bln SFP bills. This is whenthe fed funds rate started

moving up.


Even without outright asset sales, the Fed has several ways to absorb excess liquidity from

the system: Special Financing Program (SFP), reverse repos and term deposits. The latter two

are still being tested, but the SFP is already being used on a small scale. In late February, the

Fed together with Treasury committed to issuing $200 bln of SFP bills. Those purchases have

drained some $150 bln of excess reserves and sterilized another $50 bln of balance sheet

Nearly all balance sheet expansionprograms have endedProgram Expiration Date

TAF March 8, 2010 (last 28-day auction)

TSLF February 01, 2010

PDCF February 01, 2010

AMLF February 01, 2010

CPFF February 01, 2010

MMIFF October 30, 2009

TALF J une 30, 2010 for CMBScollateral, March 31 for

all other collateral

FX swaps closed February 1,2010, reopened May 10

Treasury

purchases

February 01, 2010

MBS

purchases

February 01, 2010




8/17

American Themes

21 April 2010

growth. The Fed has taken a pause, but could easily scale up SFP issuance in an effort to

continue the liquidity drain.

The Fed could also use the SFP to sterilize FX swap lines which are injecting fresh dollars into

the global financial system. As noted earlier, FX swaps could potentially increase the Fed s

balance sheet at a time when the US economy is gaining momentum. This combination could

trigger a break in inflation expectations. Sterilization is a potential solution, although the Fed

has made no such commitment to date. Sterilization would simply mean speeding up liquidity

draining operations.

Box 1: Liquidity Draining Facilities - Definitions

Reverse repos: In a reverse repo agreement, the Fed borrows funds from primary dealers in

exchange for collateral. The funds are locked up at the Fed and cannot be used for new

lending. The Fed could technically continue to roll the repos until the underlying assets

mature. Since a sale never takes place, the risk of dislocating asset prices is overcome. In a

tri-party repo, the collateral is held by a custodian bank which is responsible for theadministration of the transaction.

Reverse repose are part of standard open market operations, however the Fed wants to

expand the number of counterparties beyond primary dealers to include large money market

funds. The Fed is in a process of setting up these new counterparties.

Supplemental Financing Program: Under this program, the Treasury issues bills in excess of

its funding needs. The proceeds are then deposited at the Fed in an SFP account. This

Treasury issuance, combined with leaving the proceeds at the Fed, effectively drains liquidity

from the system.

Term Deposit Facility (TDF): This is a brand new facility which will work similarly to a

certificate of deposit (CD) offered by a commercial bank. By taking term deposits from

depository institutions, the Fed will lock up the funds which would otherwise be available for

lending.

The Fed has not yet made its final determination on maturities or how the funds will be

allocated, but based on tests which will be conducted in coming months, TDF will be an 84-

day fixed-rate instrument offered through competitive single-price auctions.

Rate outlookIn the next tightening cycle, the Fed will be operating in a completely new framework. In the

past, the Fed would establish a fed funds target and would supply the necessary amount ofreserves so that the effective fed funds rate traded at the target. Two things have changed in

the post-crisis world. First, the Fed has flooded the banking system with reserves which

sharply exceed demand for overnight funds, and secondly the Fed began to pay interest on

bank reserves. The latter is supposed to set the floor under the fed funds rate because banks

have no incentive to lend at a lower rate than they can earn risk free at the Fed. However,

there are some players in the overnight market including the GSEs and Home Loan Banks

that do not have access to the Feds deposit facility and are willing to lend below IOER

(interest paid on excess reserves). This is why the effective fed funds rate has been trading



9/17

American Themes

1 June 2010 9

below the 0.25% rate paid on reserves, and why the Fed will have a hard time realigning the

effective rate with the fed funds target.

Overnight rates a new framework

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Jan-07

Apr-07

Jul-07

Oct-07

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

Jul-09

Oct-09

Jan-10

Apr-10

% Fed Funds Target

Fed Funds Effective

Discount Rate

Interest paid On Excess Reserves (IOER)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

03 04 05 06 07 08 09 10

% Discount Rate - Fed Funds Target

The normal penalty spread is 100bps. The

differences prior to 2008 account for timinglags between FOMC and Fed Board

meetings

What sequence of rate movements?

The discount rate still has 50 bps to go if the Fed

wants to restore the pre-crisis penalty sp read of

100bps.

After that, the corri dor system descr ibed above

implies that the fed funds target rate could move

up first, followed by IOER.

Source: Bloomberg, SG Cross Asset Research

Box 2: Interest Rate Definitions

Fed funds rate: The rate at which banks lend to one another in the overnight funds market.Traditionally, the Fed used to control the fed funds rate by manipulating the supply of reserves

in the system. As a result, the effective fed funds has historically traded within a few basis

points from the Feds target. In the presence of large excess reserves, the Feds control of the

fed funds rate has weakened considerably. To regain control of short term rates, the Fed in

late 2008 began to pay interest on reserves which theoretically should set the floor under the

fed funds rate.

Discount rate: The rate at which the Fed lends to banks at the discount window on secured

basis. Prior to 2003, the discount rate was typically set below the fed funds target, though

there were high hurdles in obtaining the funds from the Fed. In 2003, the Federal Reserve

overhauled its discount lending programs and established a positive spread over the fed funds

target in order to discourage banks from arbitraging the Fed and to reduce the administrative

hurdle. Since 2003, the discount rate has averaged at about 100 bps above the fed funds

target (with difference accounting largely for timings lags between FOMC and Board of

Governors meetings. The Board is responsible for setting the discount rate at the request of

regional Federal Reserve branches.

Interest on reserves: The rate which the Fed pays on excess reserves to depository

institutions. This concept was introduced in late 2008 to restore the Fed s control of overnight

rates in the face of large excess reserves. The rate, which does not follow a strict formula, is

determined by the Board of Governors (not the FOMC). Currently, the interest rates paid on

excess and required reserves (IOER & IORR) are both set at 0.25%.



10/17

American Themes

21 April 20100

The only bullet proof way to regain control of the fed funds rate is to drain the $1 trillion of

excess liquidity from the system. That, however, is unlikely to happen quickly. To avoid losing

credibility on its rate management, the Fed could simply switch from targeting the fed funds

rate to targeting the interest paid on excess reserves (IOER).

Of course, the big question is timing. As we noted earlier, our expanded Taylor rule (with

financial conditions) suggests that the neutral rate will turn positive in the first half of 2011. In a

perfect world, the Fed would use the time between now and then to fully drain excess

liquidity, and follow up with rate hikes. However, the liquidity drain is likely to be slower and

the Fed will have to worry about the impact of its bloated balance sheet on inflation

expectations, particularly if the economy continues to improve. Rather than attempting to

drain all the liquidity at once, the Fed has said that is could simply raise the interest paid on

reserves. We believe that the first such increase could come as soon as December 2010.

Back in February, Bernanke described a corridor system where the Fed would bracket the

fed funds rate with the discount rate from above and the interest rate on excess reserves from

below. The discount rate, at which the Fed lends to banks, is currently set at 50bps above the

target. Prior to the crisis, the so-called penalty spread was set at 100bps. The Fed has already

hiked the discount rate once in February and could do so again before the official tightening

cycle begins. After that, the corridor system described by Bernanke implies that the fed

funds target rate could move up first, followed by the IOER.

The key risk factor for our Fed call is the state of financial markets. As demonstrated by our

analysis, ongoing turmoil in the financial markets would likely delay the Fed by one to two

quarters, assuming no knock-on effects on the real economy.



11/17

American Themes

1 June 2010 11

SG Forecasts

Economic forecastsAnnual year/year

2008 2009 2010 2011

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 A A E E

Real GDP -6.4 -0.7 2.2 5.6 3.0 4.5 4.8 3.4 0.4 -2.4 3.7 3.1

Real Final Sales -4.1 0.7 1.5 1.7 1.4 4.3 4.5 3.3 0.8 -1.7 2.5 3.1

Consumption 0.6 -0.9 2.8 1.6 3.5 3.9 3.6 3.2 -0.2 -0.6 2.8 3.0

Non-Resid Fixed Investment -39.2 -9.6 -5.9 5.3 3.1 8.5 11.7 7.7 1.6 -17.8 3.8 7.5

Business Structures -43.6 -17.3 -18.4 -18.1 -15.3 -10.0 -10.0 -5.0 10.3 -19.8 -14.2 -2.3

Equipment and Software -36.4 -4.9 1.5 19.0 12.7 16.0 20.0 12.0 -2.6 -16.6 12.7 10.7

Residential -38.2 -23.2 18.9 3.7 -10.7 25.0 25.0 15.0 -22.9 -20.5 6.5 12.5

Inventorie s Chg, % contibu t to GDP -2.3 -1.4 0.7 3.7 1.6 0.2 0.3 0.1 -0.3 -0.6 1.2 0.0

Net Trade, % contribut to GDP 2.6 1.7 -0.8 0.3 -0.6 -0.3 -0.1 -0.5 0.7 0.9 -0.4 -0.5

Exports -29.9 -4.1 17.8 22.8 7.2 10.0 10.0 6.0 5.4 -9.6 11.3 6.4Imports -36.4 -14.7 21.3 15.8 10.4 10.0 9.0 8.0 -3.2 -13.9 10.5 8.2

Government Spending -2.6 6.7 2.7 -1.3 -1.9 1.9 1.6 1.5 3.1 1.8 0.6 1.6

Federal Govt -4.3 11.4 8.0 0.0 1.2 3.3 2.5 2.2 7.7 5.2 3.0 2.0

State & Local -1.6 3.9 -0.6 -2.2 -3.9 1.0 1.0 1.0 0.5 -0.2 -0.9 1.3

PCE Deflator -1.5 1.4 2.6 2.5 1.5 0.3 2.4 1.7 3.3 0.2 1.7 1.8

PCE Core 1.1 2.0 1.2 1.8 0.6 0.7 1.0 1.1 2.4 1.5 1.1 1.2

CPI -2.2 1.9 3.7 2.6 1.5 0.0 3.0 2.0 3.8 -0.3 1.9 2.1

CPI Core 1.6 2.3 1.5 1.5 0.0 0.6 1.0 1.1 2.3 1.7 0.9 1.2

Unemployment Rate 8.2 9.3 9.6 10.0 9.7 9.7 9.3 8.9 5.2 9.3 9.4 8.2

Personal Income -8.9 3.3 -1.4 2.2 3.7 4.0 4.9 5.2 2.9 -1.8 3.0 4.8

Disposable Personal Income -1.2 7.7 -1.2 2.5 3.4 4.1 4.4 4.4 3.9 1.0 3.2 4.4

Real Disposable Pers. Income 0.2 6.2 -3.6 0.0 1.9 3.8 2.0 2.7 0.5 0.8 1.5 2.6

Savings Rate 3.7 5.4 3.9 3.7 3.4 3.3 3.2 3.2 2.7 4.2 3.3 3.2

Corp Profits 22.8 15.7 50.7 36.0 9.3 13.5 13.2 15.3 -11.8 -3.8 20.4 12.6

Quarterly Annualized Growth Rates

2009 A/ E 2010 E

Source: BEA, SG Cross Asset Research

Rates and FX forecasts

Central Bank Rate Forecasts current 3 mths 6 mths 9 mths 1 yr

US 0.25 0.25 0.25 0.50 1.25

Canada 0.25 0.50 0.75 1.00 1.50

10 year bond yields current 6 mths 1 yr

US 10.62 4.15 4.75

Canada 3.25 4.25 5.00

FX rates current 6 mths 1 yr

USD per EUR 1.22 1.20 1.10

USD per GBP 1.44 1.46 1.41

CAD per USD 1.07 0.96 0.95

JPY per USD 90 98 118 Source: SG Cross Asset Research

The composition of US

growth is currently

undergoing a transition from

inventories to final demand.

Inventory contributions

peaked in Q4, but were still

substantial in Q1. At the start

of Q2, we see supply roughly

realigned with final demand,

and we project only a

marginal contribution frominventories.

The good news is that both

consumers and businesses

appear to be accelerating

their spending growth. On the

basis of monthly evidence,

we currently peg Q2

consumption growth at 3.9%

while business spending on

equipment and software is

running near 16% pace. The

pickup in final demand

should ensure a continuation

of the recovery cycle even as

inventory contributions fade.

The European debt crisis

poses a risk for the US

recovery. The stronger dollar

and weaker equity markets

could shave off a few tenths

from our GDP forecasts,

although these negatives

could be offset by lower

gasoline prices and lower

mortgage rates.

On the basis of our economic

outlook, we maintain our

baseline view that the Feds

tightening cycle will

commence in December.



12/17

American Themes

21 April 20102

SG Proprietary IndicatorsSG Business Cycle Index

-15

-10

-5

0

5

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

-4

-3

-2

-1

0

1

2

3

4

5

6

SG US Business Cycle Index (LHS)

GDP, y/y (RHS)

SG Real-Time Recession Probabi lity Model

Real-time recession probabities are derived from a regime switching model using the same four co incident inditarors used by NB ER cycle

dating com mittee. These include: employment, real incom e, real sales (retail + business) and industrial production

-

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10

NBER recessionsModeled Rec. Prob

Probabil ity derived from a probit model based on employment, core inflation, ISM index and a li quidity index

Historical Perspectiv e - 6 month ahead prob ability

SG Fed Mod elRate Cut Probability Rate Hike Probability

Latest Probabilities

18%67%

92% 96%

0%

20%

40%

60%

80%

100%

3M 6M 9M 12M

probability of at least one rate cut w ithin the next 3,

6, 9 and 12 months

0% 0% 0% 0%0%

20%

40%

60%

80%

100%

3M 6M 9M 12M

Probability of at least one rate hike

within the next 3, 6, 9 and 12 months

0%

20%

40%

60%

80%

100%

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

rate cuts

Probability of at least one rate cut within next 6 months

0%

20%

40%

60%

80%

100%

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

rate hikes

Probability of at least one rate hike within next 6 months

Source: SG Economic Research

The US economy is clearly

out of a recession regime,

but growth is slowing from

the breakneck pace

registered at the turn of the

year. Financial conditions

are the key downside risk

in our economic scenario.

Our business cycle index

has slowed notably in

recent weeks. The

slowdown reflects primarily

tighter financial market

conditions and is not yet

evident in the economic

data. In part, the

deceleration is also

consistent with the

transition to demand-led

growth which is slowing

GDP growth from the 5.6%

peak in Q3 towards a 3%-

4% range. For now, we do

not think that the recent

market turmoil will derail

the US recovery, but

financial conditions do

pose a risk and need to be

monitored closely.



13/17

American Themes

1 June 2010 13

Rates and Short-term FundingFed Funds Expectati ons

Real Treasury Yie lds

A1/P1 Non fin CP vs. OIS (3m) ABCP vs. OIS (3m)

Rates

Libor vs. OIS (3m) - Historical and Implied

Treasury Yield Curve (10y - 2y)

Short Term Funding

Inflation Expectations

0.00

0.25

0.50

0.75

1.00

6/10 8/10 10/10 12/10 2/11

%

Latest

Week ago

Month ago

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1/09 4/09 7/09 10/09 1/10 4/10

-0.2

-0.1

0.0

0.1

0.20.3

0.4

0.5

1/09 4/09 7/09 10/09 1/10 4/10

0.0

0.5

1.0

1.5

2.0

2.5

1/09 4/09 7/09 10/09 1/10 4/10

5yr real

10yr real

1.0

1.5

2.0

2.5

3.0

3.5

1/09 4/09 7/09 10/09 1/10 4/10

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1/09 4/09 7/09 10/09 1/10 4/10

10yr breakeven

5yr 5yrs forward

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

J an-

07

Apr-

07

J ul-

07

Oct-

07

J an-

08

Apr-

08

J ul-

08

Oct-

08

J an-

09

Apr-

09

J ul-

09

Oct-

09

J an-

10

Apr-

10

J ul-

10

Oct-

10

%

Source: Bloomberg, SG Economic Research

European sovereign debt

issues have induced

significant corrections

across the financial market

over the past month.

1. Libor rates both spot

and implied forwards

have risen substantially.

The rise is driven primarily

by European banks whoseaccess to wholesale dollar

funding was impaired

following sovereign

downgrades of several

European countries.

2. Liquidity pressures and

in some cases forced de-

leveraging have triggered

sharp corrections in equity,

commodity and credit

markets, and in high-

growth currencies.

3. Financial turmoil has

pushed back expectations

for the Feds tightening

cycle. Markets are now

pricing the first rate hike

around Q1-Q2 2011.

4. Soft inflation data,

weaker commodity prices

and concerns about the

impact of austerity

measures have pushed

back inflation expectations

implied by the TIPS

market. The 10yr

breakeven is now trading

at lowest levels since late

2009.



14/17

American Themes

21 April 20104

Credit AvailabilityMortgages & Consumer CreditConformi ng Mortgage Rate

ABX AAA Tranches

Corporate Credit

Swap Spread (10yr)

HY Spreads(Lehman HY - 10yr Swap)

Inv Grade Corp SpreadDJ Inv Grade CDX Index

Sector CDS Spreads

Fannie/Freddie MBS Spreads

Consumer ABS Spreads

0.40

0.80

1.20

1.60

1/09 4/09 7/09 10/09 1/10 4/10

Fannie/Freddie MBS vs . swap

20

30

40

50

60

70

80

90

100

1/08 4/087/0810/081/09 4/097/0910/091/10 4/10

index 2006-1

2006-2

2007-1

2007-2

3.5

4.0

4.5

5.0

5.5

6.0

1/09 4/09 7/09 10/09 1/10 4/10

30yr Fannie MBS

30yr Conforming Mortgage Rate

0

200

400

600

800

1000

1200

1/09 4/09 7/09 10/09 1/10 4/10

bpcredit cards

autos

0

50

100

150

200

250

300

1/09 4/09 7/09 10/09 1/10 4/10

-20

-10

0

10

20

30

40

50

1/09 4/09 7/09 10/09 1/10 4/10

600

800

1000

1200

1400

1600

1800

2000

2200

1/09 4/09 7/09 10/09 1/10 4/10

0

50

100

150

200

250

300

350400

450

1/09 4/09 7/09 10/09 1/10 4/10

Financials

Industrials


European sovereign

concerns have led to some

re-widening in corporate

credit spreads, particularly

in the financial sector.

Notably, the impact on US

financials has not been as

pronounced as that seen inEurope given limited

exposure of US banks to

European assets.

It has been mixed news for

the residential mortgage

market. Sub-prime values

declines with all risky

assets, but MBS yields fell

with Treasury yields that

were pulled down by safe

haven flows. As a result,the 30yr conforming

mortgage rate fell below

5% to match lowest levels

of this cycle. Jumbo

mortgage rates have fallen

even more impressively to

lowest levels in 5 years.



15/17

American Themes

1 June 2010 15

FX MonitorDollarMajor Dollar Index

USD/EUR

Carry Trade Index

Carry-to-Risk Ratio

Yield Differ ential

Implied Vol

FX Volatility (G10 avg)

JPY/USD

5

10

15

20

25

30

1/09 4/09 7/09 10/09 1/10 4/10

70

72

74

76

78

80

82

84

86

88

1/09 4/09 7/09 10/09 1/10 4/10

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

99 00 01 02 03 04 05 06 07 08 09 10

%

+/- 1St Dev range

More

attractiv

Less

attractiv

1.02.0

3.0

4.0

5.0

6.0

00 01 02 03 04 05 06 07 08 09 10

5

15

25

35

00 01 02 03 04 05 06 07 08 09 10

100

110

120

130

140

150

160

170

1/00 7/00 1/01 7/01 1/02 7/02 1/03 7/03 1/04 7/04 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 1/10

80

85

90

95

100

105

1/09 4/09 7/09 10/09 1/10 4/10

1.1

1.2

1.2

1.3

1.3

1.4

1.4

1.5

1.5

1.6

1/09 4/09 7/09 10/09 1/10 4/10


Since late November, the

dollar has strengthened

20% against the euro and

we expect the trend to

continue toward 1.10. On

the surface, this poses a

potentially big hit to US

exporters. However, the

impact depends on what

happens to other

currencies, notably toemerging Asia.

In our main scenario, EM

and commodity currencies

should continue to

strengthen vis--vis the

dollar, offsetting much of

the euro weakness.

Indeed, this pattern has

been in place between

November and April when

the trade-weighted dollarindex gained only 2%.

Recently, deleveraging and

risk aversion have led to

some weakness in

EM/commodity currencies,

however we do not expect

this to be sustained.

Ultimately, we look for

further strengthening of

Asian and commodity

currencies which would

mitigate the impact ofweaker euro and promote

rebalancing of trade

between the US and the

emerging world.



16/17

American Themes

21 April 20106

Commodities and EquitiesCrude Oil (Nymex WTI)

Copper

Telecom -3.9%

Co nsumer Staples -4.8%Utilities -6.4%

Health Care -6.7%

Consumer Discretionary -7.0%

IT -8.1%

Financials -9.0%

Materials -9.2%

Industrials -9.6%

Energy -11.9%

VIXVolatility Skew

(25 delta put - 25 delta call, SPX Index)

Sector Perform ance - 4 wk chg

Equities

Baltic Dry Index

GoldCommodities

20

40

60

80

100

1/09 4/09 7/09 10/09 1/10 4/10

500

600

700

800

900

1000

1100

1200

1300

1/09 4/09 7/09 10/09 1/10 4/10

0

10

20

30

40

50

60

1/09 4/09 7/09 10/09 1/10 4/10

0

2

4

6

8

1012

14

16

18

1/09 4/09 7/09 10/09 1/10 4/10

0

50

100

150

200

250

300

350400

1/09 4/09 7/09 10/09 1/10 4/10

500

1000

1500

2000

2500

3000

3500

4000

45005000

1/09 4/09 7/09 10/09 1/10 4/10


Equity prices are a

downside risk to the

recovery, although we do

not yet see the declines as

deep enough to induce

major behavioral changes

by the consumers. The

main transmission channel

would be the savings rate

which over long periods of

time correlates well with

household wealth

positions. So far, equity

price declines have not

been deep enough to alter

the wealth/income ratio

substantially. Importantly,

home prices are no longer

declining and are even

rising in some areas. This

should also mitigate

negative wealth effects

coming from equity prices.

So far, we see no spillover

into consumer confidence

which continues to

improve gradually.

Like lower mortgage rates,

lower commodity prices

offer an offset to some of

the negative effects

associated with the

European sovereign crisis.

On the basis of recent

price declines, we estimatethat CPI headline will

contract by 0.2% m/m in

both May and June. This

will add a substantial boost

to consumer fire power.



17/17

American Themes

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SocGen - Will Europe delay the Fed?

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